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Opalesque’s Emerging Manager Monitor

ISSUE 01 • • January 2012 ISSUE 01 September 2011

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

In This issue
Editorial ….....................................................................…. 3 Emanagers Indices
December performance of Opalesque’s very own indices of emerging managers’ funds .................................................. 4

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Launches

A recapitulation of maiden launches last month. We included Julian Roberson’s recent comment on new hedge funds, and HFR’s findings related to hedge funds launched in 2011 …....................................................................................... 25

Emerging Managers: Statistics

Peter Urbani explains how emerging managers actually add significant alpha, and observes the overall performance of the top 10 funds in the Emanagers indices ......................... 6

The Analytical View

Recent research and surveys relating to emerging hedge fund managers …............................................................... 26

Focus

Profiles

Part 1 looks at how emerging managers are dealing with current high levels of scrutiny from regulators and investors. Four experts give their view points on the matter. Part 2 (page 19) looks at regulator’s actions since ’08, their warning criteria, and the number of frauds in recent years …... 18

Emerging hedge fund managers, who were interviewed by Opalesque, comment on the late 2011 performance of their funds ….............................................................................. 29

Perspectives

Hedge fund industry players discuss emerging managers .... ............................................................................................ 32

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Editorial
Welcome to the first issue of New Managers, Opalesque’s monthly monitor of emerging managers. Apparently, the number of hedge fund launches in 2011 (including maiden funds) might be the highest, within a calendar year, since 2007 when nearly Benedicte Gravrand 1,200 funds were launched. And many expect more new entrants in the industry coming from larger fund houses and banks. However, with less trading opportunities in a crowded environment, more involved regulators and investors no longer content with opacity, the environment requires a little more effort to navigate. Now is a great time to put the spotlight on the trials, tribulations and opportunities that emerging managers are facing; as information is key for better navigation. Our first issue is jam-packed with useful data. First, the number crunchers: Florian Guldner gives you the December results for Opalesque’s Emerging Managers (EManagers) indices. Peter Urbani then deconstructs the funds contained in the indices with relish, and shows how emerging managers add significant alpha, in “Statistics.” I then provide you with a series of topical articles. This month’s “Focus” piece looks at how emerging managers are dealing with current high levels of scrutiny from regulators and investors (especially in the U.S.) – who are reacting to the Madoff scandal and a greater awareness of the financial frauds going on. David Sung, a hedge fund manager, Alissa Douglas, an investor, Dennis Heskel, a platform provider, and Rich Goldman, a lawyer, give their view points on the matter. Part 2 of the article relates the recent actions taken by regulators, their warnings and the number of frauds this side of the century.

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“Launches” recapitulates the maiden fund launches last month with comment; “The Analytical View” recounts recent analysts’ findings on emerging managers; in “Profiles”, emerging hedge fund managers, who were interviewed by Opalesque, comment on the late 2011 performance of their funds (which feature in Opalesque’s EManagers database); and in “Perspectives”, hedge fund industry players discuss the challenges and opportunities in store for emerging managers and give appropriate advice. I hope New Managers will be of benefit to you. Do contact me if you have any related news. Benedicte Gravrand Editor gravrand@opalesque.com

Opalesque New Manager is edited by Benedicte Gravrand. Based in Geneva, Switzerland, Benedicte also writes exclusive stories, special reports, co-edits Opalesque’s daily hedge fund publication Alternative Market Briefing (AMB) and occasionally moderates Opalesque Roundtables. Benedicte is perfectly bilingual (French/English) and has lived in Paris, Geneva and London. She obtained a BA (Honours) in Philosophy from the University of London, worked in the publishing sector, the hedge fund industry and then joined Opalesque in 2007.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emanagers Indices
Emanagers Total Index up 0.12% in December (-1.83% in 2011), emerging managers outperform fund universe again in 2011
Florian Guldner, Opalesque Research: Opalesque Ltd., a leading provider of online information services to the alternative investment industry, reports the estimated December and year-end results for its series of indices tracking emerging hedge fund and managed futures fund managers. Index calculations are based on currently 295 funds listed in Opalesque Solutions’ Emanagers database, the industry’s only database dedicated exclusively to fund management firms less than 48 months old and with assets under management of less than $600 million at the time of the firm’s inception. According to a first estimation, The Emanagers Total Index, consisting of both hedge funds (65%) and managed futures funds (35%), gained 0.12% in December, finishing the year 2011 down 1.83%. Over the last three years, the index rose almost 57% with gains of 34.5% in 2009 and 18.7% in 2010.

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While the Emanagers Hedge Fund Index lost 0.22% in December (-2.50% in 2011), managed futures funds tracked by the Emanagers CTA Index gained 1% (+0.23% in 2011).

Our data shows that emerging manager hedge funds and CTAs outperformed the broad fund universe every year since 2009.
Index Dec 2011 2011 2010 2009 Volatility Equity market beta 5.85 8.70 3.71 31 48 1

Emanagers Total Index Emanagers Hedge Fund Index Emanagers CTA Index Eurekahedge Hedge Fund Index Newedge CTA Index MSCI World

0.12 -0.22 1.00

-1.83 -2.50 0.23

18.73 17.07 19.15

34.51 37.59 20.52

-0.28 0.46 -0.17

-4.21 -4.45 -7.61

10.74 9.26 9.40

20.37 -4.31 27.07

5.23 8.41 17.66

28 5 100

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emanagers Indices
Over the last 12 months, Emanagers hedge funds were more volatile than their peers tracked by the Eurekahedge Hedge Fund Index and experienced a slightly higher correlation with the stock market, resulting in a higher equity market beta of 48% compared to 28%. Emanagers managed futures strategies had not only the least volatile 2011 results of all time series analyzed, but also the smallest correlation (+5%) with the MSCI World index. As a result, the equity market beta of the Emanagers CTA Index was below 1%, proving that managed futures strategies achieved their goal of providing returns with virtually no stock market correlation.

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ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics
Emerging Managers add significant alpha
By Peter Urbani: An analysis of the funds contained within the Opalesque Solutions Emerging Managers (Emanagers) Index shows the following: The Emanagers Total Index has delivered very substantial excess returns to the broader Eurekahedge Hedge Fund Index over the past three years since inception. On average the three Emerging Manager Indices calculated by Opalesque (Emanagers Total Index, Emanagers HF Index and Emanagers CTA Index) have produced 700 – 800bp in additional returns per annum over their respective equivalent Eurekahedge Indices. Drawdowns for the period were 47%, 44% and 19% lower than the drawdowns for the equivalent Eurekahedge Indices.

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Peter Urbani is the former CIO of Infiniti Capital, a now defunct Hong Kong-based Fund of Funds group. Prior to that, he was Head of Quantitative Research for Infiniti, Head of Investment Strategy, Head of Portfolio Management, Head of Research and Senior Portfolio Manager for number of buy-side firms. He started out in stock-broking as an open outcry floor trader in the late 1980’s. Some of his VBA code was included in Kevin Dowd’s Measuring Market Risk and he specialises in Risk Management and Portfolio Constriction.

Risk Disclosure: Past performance is not always indicative of future results. This newsletter addresses sophisticated topics of volatility and risk, it is written for professional investors and is not appropriate for all readers. The newsletter may include frank discussions of investment volatility and how market environments can influence strategy drivers, which are considered opinions and may not have considered all risk factors. See full risk disclosure at the end of this document.
ISSUE 01 • January 2012 New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics
Emerging Managers versus Eurekahedge HFI
0.03 0.025 0.02 0.015 0.01 0.005 0 -0.005 -0.01 10.0% 5.0% 0.0%
Opalesque Emerging Managers Excess Returns (Lhs) Opalesque Emerging Managers Cumulative Excess Returns (Rhs)

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25.0% 22.8% 20.0% 15.0%

Emerging Manager CTA's versus Eurekahedge CTA / Managed Futures HFI
0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 -0.04
Opalesque Emerging Manager CTA Excess Returns (Lhs) Opalesque Emerging Manager CTA Cumulative Excess Returns (Rhs)

30.0% 25.1% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% -5.0%

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics
Emerging Manager HF's versus Eurekahedge HFI
0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03
Opalesque Emerging Manager HF Excess Returns (Lhs) Opalesque Emerging Manager HF Cumulative Excess Returns (Rhs)

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30.0% 25.0% 24.9% 20.0% 15.0% 10.0% 5.0% 0.0%

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics
Emerging Managers beat equities with significantly less risk
In addition to beating their respective broader Hedge Fund indices, the Opalesque Solutions EManager indices also managed to beat Equities as proxied by the S&P500 Total Return Index over the period. They did so with only a third as much volatility as Equities and only 40% of the drawdown experienced by Equities. The Expected Tail loss (a.k.a ETL, Expected Shortfall, CVaR) for the Emerging Managers Index was also only a quarter of that for Equities at -2.8% versus -11.1% at the 95th percentile. Although both the Emerging Managers and S&P500 Indices test as having distributions that are ‘Normal’ a Johnson Lognormal distri-

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bution was a slightly better fit for the S&P500. Whilst the broader indices are generally normal – near normal ( with the exception of CTA’s ) most of the time, individual funds have return distributions that can and do differ significantly from Normal at least 25% of the time. In addition, better fitting distributions that are either nearnormal ( Modified Normal, Mixture of Normals, Johnson Lognormal and Johnson SU ) or not normal ( Gumbel Min and Gumbel Max ) can be found most of the time. Of these non-normal distributions provide the best fit 30 – 40% of the time with Normal or near-Normal distributions being chosen 60% of the time.

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3

Opalsque Emerging Managers versus Eurekahedge and S&P500
Opalesque Emerging Manager HF Index Eurekahedge Hedge Fund Index S&P500 TR

Best Fit Distributions
Best Fit EM Total Index PDF (Normal)

0.569082557 0.47082746
Best Fit VaR -2.0%

28.1%

Best Fit S&P500 TR PDF (Johnson (Lognormal))

Best Fit CVaR -2.8% Best Fit VaR -8.3% Best Fit CVaR -11.1%
-25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

VaR (

0.1

0.15 0.2

Emerging Managers: Statistics
Only 3 out of 4 funds have normally distributed returns

-6

-4

-2

0 Skewness

2

4

6

10

Strict Normality Testing

24%

76%
Normal Not-Normal

Best Fitting Distributions
In those cases where a better fitting distribution can be found the normal distribution is chosen only 7% of the time with near-normal distribution types being selected 63.5% of the time and non-normal Gumbel Max or Gumbel Min distributions 36.5% of the time. CTAs are a good example of strategy which does not have normally distributed returns. This is because of the significant Positive skewness of +2.85 for this index. It is this positively skewed distribution and ( so far ) bounded downside that makes CTA’s an attractive strategy to hold in conjunction with Equities.

Gumbel (Max) 23.3% Gumbel (Min) 13.2% Johnson (Lognormal) 13.2% Johnson (Unbounded) 2.6% Mixture of Normals 15.9% Modified Normal 21.2% Normal 6.9% Uniform 3.7%

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Hedge Fund Database

Emerging Managers: Statistics
A word of caution on the Modified Distribution
It has become popular to use the Cornish Fisher modification to the normal distribution to add the impact of skewness and kurtosis to fund distributions and Value at Risk (VaR) calculations. This is generally called mVaR OR ‘modified’ VaR.

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Secondly the Cornish Fisher modification also suffers from Poor Tail behaviour particularly at high confidence levels where you need it the most. These may cause the Cumulative Distribution (CDF) function to turn either in the body or more seriously in the tail of the distribution.
100.00%
Modified CDF Normal CDF

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80.00%

?
S
S

Kurt

60.00%

Unfortunately the Cornish Fisher modification suffers from two rather serious drawbacks that many users may not be fully aware of. Firstly, it is not strictly monotone with respect to the confidence level and skewness being used. This means that it is possible to get a VaR number at a higher confidence (e.g. 99%) level that is lower than one at a lower confidence level (e.g. 95%.)

40.00%

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20.00%

S

0.00% -0.5 -20.00% -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4

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Modified PDF Normal PDF

2500.00%

Z

Good

Z

2000.00%

1500.00%

0

?
Z
-6 -4 -2 0 2 4

Skew

-0.1 -0.05 0 VaR ( Modified ) 0.05 0.1

Modified VaR as a function of Skewness
Modified VaR @ CL 99.00% Modified VaR @ CL 95.00% Current Current

1000.00%

500.00%

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-20.0% -10.0% 0.0% 10.0% 20.0% 30.0%

0.00% -30.0%

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0.15 0.2

As you can see from the examples shown these problems occur even at low levels of excess skewness and kurtosis and not only at high levels as some people believe. Moreover, it affects fully 50% of all hedge funds so great caution should be used particularly when using this calculation at confidence levels above 95%.
-6 -4 -2 0 Skewness 2 4 6

A simple test for the appropriateness of the Cornish Fisher expansion can be downloaded here

ISSUE 01 • January 2012

Strict Normality Testing

New Managers | Opalesque’s Emerging Manager Monitor

Normal 6.9% Uniform 3.7%

Emerging Managers: Statistics
Hedge Fund Database
5%

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44%

51%

OK WARNING: Degenerate Cornish Fisher. CDF will turn in tails WARNING: Degenerate Cornish Fisher. CDF will turn in body

As this issue affects so many funds we would strongly recommend testing before using the expansion. In the accompanying Index statistics table to the right you can see that the Cornish Fisher expansion is not recommended for any of the Indices shown except for the Eurekahedge Hedge Fund Index (EHHFI) where the Modified Normal distribution is the best fitting distribution. You can also see how the expansion causes the statistics for the EManager CTA Index to be potentially misleading and inaccurate ( see in red ).

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics
Emerging Managers database’s TOP 10 funds

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The Opalesque Solutions Emanagers (EM) Total Index consists of two sub-indices being the EM CTA Index and the EM Hedge Fund (HF) index. The make-up of the database is roughly one third CTAs and the balance Hedge Funds. Rather than single out individual funds, I have chosen to comment on the overall performance or ranking of the top 10 funds for a number of different statistics and then show which funds ranked most often in each category. This means that more than 10 funds are shown and the 36 funds listed below provide a sneak preview to just under 20% of the Database. The table below is sorted by the ranking of the Cumulative Prospect Theory Certainty Equivalent (CPTCE) which embodies the descriptive risk preferences described by the Nobel prize winning pair of Amos Tservsky and Daniel Kahneman.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics

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The Table on the left illustrates that a fairly high percentage of the Top 10 ranked funds in each category have returns that are not normally distributed. On average 32% of the funds are judged to be not-normally distributed.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics

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Similarly the Table on the left illustrates the best fitting distribution for all of the funds in the Top 10 rankings as well as which of them fail the Cornish Fisher feasible region test.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics

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ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Emerging Managers: Statistics
Interactive screening tool for ranking and sorting funds by over 120 statistics

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ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
Part 1 – Ghost-busting frauds of the past: a challenge for new managers
“Hedge funds are less encumbered by government regulation, less transparent to investors, play more complex games, take bigger risks, and capture the public imagination in a way that their lesser counterparts have difficulty approaching. These unique features have resulted in an increasing scale of losses due to fraud, with no corresponding increases in safeguards available for investors,” says Bruce Johnson in his book, The Hedge Fund Fraud Casebook (Wiley, 2010). This would mean that emerging managers would be grappling with the “dark side of hedge funds’ secretive world.” This is not really the case anymore, however. Now investors, regulators and investigators are more vigilant than ever through more focused due diligence, required registrations and check-ups; a high level of transparency from managers is the new black; and new regulations are being implemented all around to better harness the wild spirits and the bad apples (such as Dodd-Frank in the U.S. and the AIFMD in the EU). So the risk of being victim of a hedge fund fraudster is lessening – a little bit. What does it mean for newcomers? It is already hard for new hedge funds to raise new capital and to meet new demands from investors and regulators. But are frauds of the past haunting their struggling beginnings? According to most of the experts interviewed by Opalesque, the answer is; not in a bad way. Frauds of the past can be ghostbusted with more thorough DD (due diligence), better operations and reputable independent service providers. When asked, to what extent the amount of financial frauds in the U.S. is deterring investors from investing in emerging managers (particularly hedge fund managers), they replied; not as much as one would think.

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The emerging hedge fund manager
This new manager, who launched his first fund, a U.S.-based market neutral hedge fund called Betzwood Partners, LP, in 2009, took the new regime in his stride; using the services of respected services providers and complying with demands is a not such a high price to pay.
David Sung

“We have seen that issue [the number of frauds] in particular dissipate quite a bit since Bernie Madoff,” portfolio manager David Sung told Opalesque. “It has highlighted the value of well-known and well respected third party service providers, which I believe, as long as you’re ticking the box with a good auditor, with a good fund administrator, that issue resolves itself. The days of self-clearing, self-administering for smaller funds, or even bigger funds, are over.” (see past Opalesque Exclusive on his fund).

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
And even if it is not administrators’ job to detect fraudsters, they have direct access to the fund’s prime brokerage statements and can perform independent third party analysis in the fund’s activity, he explained. So administrators can make hard confirmation that the capital is there, and they can verify the P&L. And even if being registered with the SEC is not enough to prevent frauds, working with an administrator and an audit firm are really good steps in that direction, he said. “Everyone has stepped up their level of scrutiny, making sure that those independent checks are in place,” he concluded. “We got questions regarding third parties, service providers, and controls on money moving in and out of the fund.”

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For example, she is now seeing a lot of new managers hire not only senior investment people but also senior operational people; which shows they are taking the operations side of the business as seriously as the investment side. CM also checks that the service providers that are indicated in the DDQ are what they are. “A small percentage of people out there don’t have good ethics and will continue to try to cheat the system,” she noted. “It’s our job as fiduciaries to make sure we’re investing with people who have high ethics, that we are doing our due diligence to make sure that not only they have hired the right people, but also that we’ve met with those people, gone through their processes and procedures, and are comfortable that they’re taking steps to alleviate any problem in their organisation.”

The investor
As mentioned, investors are more vigilant than ever. They know that fraud will happen in some cases. They just have to keep their antennas open to make sure they are not victims in what could be a jungle-like environment – and they’ve had to do that for a long time – since financial transactions of all sorts were invented.

The investment solutions provider
Here is one solution to preventing hedge fund fraud that was put forward: managed accounts. “As a result of a number of high profile investment frauds over the previous several years, we at LYXOR Asset Management have seen a significant increase among institutional investors in utilizing managed accounts for their investments into hedge funds,” Lyxor’s Head of Hedge Fund Research in New York, Dennis Heskel, PhD, told Opalesque by e-mail (see latest Opalesque Exclusive on Lyxor). According to Heskel, managed accounts provide a good way to access both emerging hedge fund managers as well as established funds while minimizing fraud concerns. This is because managed account platforms offer segregation and control of assets. The assets are segregated from the benchmark manager and subject to third party oversight and valuation.

Alissa Douglas

“There is definitely an increased list of fraud, given the small size of newer hedge funds,” Alissa Douglas, Director, Hedge funds and Public Market, for U.S.-based family office CM Capital Corporation told Opalesque (see past Opalesque Exclusive and video interview of Alissa Douglas). When CM Capital looks at new managers, the firm makes sure that those managers have dedicated the right amount of resources for making sure that their operations are institutional, she explained.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
“Together, these elements act to help mitigate the risk of fraud or misappropriation of assets,” he concluded.

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The lawyer
Rich Goldman, partner at the Bostonbased Investment Management Group of international law firm Bingham McCutchen LLP, told Opalesque that he does not think frauds are deterring investors. Although the latter, once bitten, twice careful – but still attracted to the new talent – are now being more diligent and taking more time before they invest. There are many investors out there who want to invest with the many new talents that are launching hedge funds, but the number of financial frauds has required institutional investors to do a lot more due diligence (DD) before investing, he said. The investment process is, consequently, slower. “Investors are certainly doing more DD not only on a manager’s investment process, but on the operations as well, such as conducting background checks on the investment manager’s key personnel,” he explained. “They have to do more work to confirm that the manager is who it says it is. But there is a healthy appetite in the institutional community for investing with emerging managers.” Private high net worth investors (HNWIs) are also investing with emerging managers, he noted, although more of the asset flows into hedge funds during the past few years have come from institutional investors (sovereign wealth funds, pension plans, endowments). HNWIs recognize that emerging managers, being
Rich Goldman

smaller and sometimes more nimble, can often be a benefit. However, as those investors often have fewer resources to conduct comprehensive DD, they may instead invest in emerging managers through funds of funds, or employ third parties to conduct DD on those managers. Goldman has noticed that some investors are asking for more transparency from emerging managers and want to be able to call on certain independent third parties for information. “One important factor for investors is to consider who these independent third parties are (the accounting firm, the administrator, etc.) to make sure that they are themselves reputable,” he continued. “This was not the case in the Madoff situation.” Bingham itself sometimes conducts DD on managers. The DD that investors conduct can be quite extensive, according to Goldman. In addition to asking a manager to fill out a questionnaire, investors will want to meet the manager and his or her front and back office teams, look at the systems and really get comfortable that there is a viable operation and infrastructure in place. Investors who are suspicious of a fund manager that they have invested with may make use of service providers to assist them with their investigation of the manager, he noted: “As legal counsel to many institutional investors, they would ask us to look more closely at their legal rights, particularly if they want to withdraw capital. We may also assist them for instance, if they hadn’t done so previously, with reviewing regulatory filings made by the manager and to look to see if managers have had any regulatory violations.” But emerging managers are clever. Bingham is seeing an increase in the number of quality emerging managers that are launching

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
funds with a team larger than several years ago. Indeed, managers recognise that institutional investors want to see a reasonably good infrastructure in place, even though their assets under management are small. Goldman thinks that we hear about financial frauds more frequently than we did in the past for a number of reasons: (1) Investors and regulatory authorities are more sophisticated and have more means at their disposal to detect fraud, (2) The SEC has more resources and the staff is more experienced than they had been in the past, (3) When the SEC or another regulatory agency identifies a fraud or other regulatory violations, they are publicly disseminating the information, and (4) Given the global world in which we live where communication is so much easier, we are hearing about more violations on an international basis than we might have before. “Unfortunately, we often only hear about the negative activities in our industry,” he concluded. “We see that managers are much more focused on compliance matters and adopting best practices, not only to provide investors with comfort, but also because they recognize that it is the proper way to run an investment management firm.” As you will see in Part 2 of the article, there is less fraud now, not more. It’s just that we hear more about them, about every day in fact. General dissemination of information does indeed make people behave more ethically - and pushes the financial industry’s new generation to a wiser behaviour.

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ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
Part 2 – Background: The regulator is watching you
In November 2009, U.S. President Barack Obama established an interagency Financial Fraud Enforcement Task Force to strengthen efforts to combat financial crime. Treasury Secretary Geithner then said: “It’s not enough to prosecute fraud only after it’s become widespread. We can’t wait for problems to peak before we respond. We’re seeking comprehensive financial reform to create a more stable, safer financial system and stepping up our enforcement strategy.” That same month, the U.S.’ Securities and Exchange Commission (SEC), in the latest move in its ongoing case against convicted Ponzi schemer “Bernie” Madoff, charged two computer programmers for their role in helping cover up the fraud at Bernard L. Madoff Investment Securities LLC (BMIS) for more than 15 years. The Madoff fraud, uncovered in late 2008 just as the financial markets were in terrible predicament, shook up Wall Street. It was not the first fraud – far from it – nor is it the last. But it was considered to be the largest financial fraud in U.S. history (with almost $65bn missing from thousands of client accounts). Financial fraud is like the odd bad apple that comes in a basket of otherwise good ones. There will always be one at some point no matter what. Madoff’s apple was rotten to an advance stage, in a basket where some others were not looking too good either. Regulators strongly reacted to the Madoff case – all the more as they had ignored whistleblowers’ warnings and were consequently criticized for it.

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IBefore and after Madoff, other fraud cases became famous, as for example: LTCM (lost $4.6bn in1998 following the Russian financial crisis, and had to be bailed out) and more recently, R. Allen Stanford (financier alleged to have conducted a $7bn Ponzi scheme), Marc Dreier (lawyer doing 20 years for selling more than $400m in phony notes to hedge funds), Arther Nadel (hedge fund manager who stole $168m, sentenced to 168 months in 2010), Bayou (managers issued false financial statements following losses), Tom Petters (sentenced to 50 years in 2010 for running a $3.65bn hedge fund Ponzi scheme), Galleon (owner Raj Rajaratnam serving 11 years for hedge fund insider trading), to name just a infinitesimal few. The SEC is now getting its act together. It is currently monitoring, with a new computerised system, monthly returns of thousands of hedge funds (and more recently, mutual funds and private equity funds). Around a hundred hedge funds which are deemed to have a performance that is too good to be true, are being watched closely. “There is serious fraud in this space, and we have been attacking it,” Bruce Karpati, co-chief of the SEC’s asset management enforcement unit told the WSJ last month.

How to avoid fraud
In a release to investors in early 2008 (Hedging Your Bets), the SEC recommended studying the fund’s prospectus and Offering Memorandum to understand the level of risk, making sure to understand how assets are valued, asking about the fees, about

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
the right to redeem, and researching the backgrounds of hedge fund managers (by reviewing Form ADV for example). Since 2008, all these issues (risk, valuation, fees, redemptions, manager’s background) have come under the spotlight. Risk is being redefined and refocused; new tools for measuring risks are being created and the topic is under scrutiny.Charles Hage, a compliance officer at Monican Financial Management, recently wrote in a paper published on Opalesque that “in the core subject of portfolio risk, the hedge fund industry clings to misconceptions, is less than honest with itself, and misleads investors.” Valuation, which is often discretionary, also continues to be a controversial topic. Now investors are seeking ever more transparent and accountable data from managers and administrators about valuations, making it one of the riskiest tasks for fund executives (see recent Opalesque Exclusive on the matter). Fees have been lowered since 2008. More recently, both management and incentive fees charged by hedge funds in general declined in 2011, confirmed Hedge Fund Research. Redemption terms made the headlines in ‘08 and ‘09 as investors saw their money blocked in funds which had been overwhelmed with redemption demands. Since then, preachers of alignment between liquidity (of underlying instruments or funds) and redemption terms spoke out in numbers. According to a Preqin survey out in September 2011, 46% of investors prefer the more common quarterly redemptions, while 32% would rather have monthly redemption terms. Meanwhile, 30% of hedge fund managers have shortened redemption periods since 2008. Managers’ background can be checked through several regulators

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and private eyes. As early as 2005, it was reported that hedge fund sleuths could be hired for $1,000 or multiples of that, to check on partnerships and their managers. The SEC goes on to say that common fraud cases involve: • Hedge fund advisers who misrepresent their experience and the fund’s track record; • Classic “Ponzi schemes,” where early investors are paid off to make the scheme look legitimate; and • Hedge funders who send phony account statements to investors to camouflage the fact that their money had been stolen.

FBI’s indicators
The current investment climate, which lacks regulatory scrutiny, may tempt unscrupulous hedge fund managers to commit fraud, says the Federal Bureau of Investigation (FBI) in a release for investors, which goes on to list several indicators of fraud in hedge funds, namely: • Lack of trading independence - hedge fund managers trading through affiliated broker\dealers; • Investor complaints - investors being unable to redeem their investments in a timely fashion; • Audit issues - lack of audits by reputable independent accounting firms; • Litigation - hedge funds being sued civilly by investors alleging fraud; • Unusually strong performance claims - hedge fund performance claims are better than market average over a long period of time; • Illiquid investments - investing in a commodity which is not easy to value (incentive to overvalue investment to earn a larger commission); • Valuation issues - use of related parties to value illiquid investments or use of a non-independent fund administrator;

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Focus
• Personal trading - hedge fund managers trading in their own accounts; • Aggressive Bear Shorting - hedge funds take a short position in a stock and orchestrate efforts to disseminate unfounded or materially false negative information about the stock, eroding the price and allowing the perpetrators to profit on the short position. The FBI has been looking at financial frauds for a while, but the Galleon case shone a light on the agency’s active role in hunting for fraud. Apparently the bureau currently has quite a few hedge fund managers on wiretap. reported 1,251 new prosecutions were filed. The U.S.’ financial arena might just be a safer place.

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Note: At the time of press, seven people were charged in a Manhattan federal court with counts including securities fraud and conspiracy as part of a five-year probe of insider trading at hedge funds by the FBI and the Justice Department (Bloomberg).

Around 28% less prosecution in 2001 than five years ago
Apparently, the FBI was the lead investigative agency for financial institution fraud prosecutions through August 2011, accounting for 37.6% of them. Regulators’, fund managers’ and investors’ diligence is paying off. According to a TRAC (Transactional Records Access Clearinghouse) report in November 2011, U.S. federal prosecutions for financial institution fraud have continued their downward slide despite the financial troubles reported in this sector. Indeed, the latest available data from the Justice Department show that during the first eleven months of FY 2011 the government
Figure 1: Criminal Financial Institution Fraud Prosecutions over the last 20 year Source: TRAC

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Launches
Maiden launches announced in December 2011
At Opalesque, we heard of the following maiden launches during December 2011: Alex Denner, who has a Ph.D. in biomedical engineering, split from activist investor Carl Icahn to start his own hedge fund; Eashwar Krishnan, a former analyst at hedge fund Lone Pine, and Tanvir Ghani, former head of capital introduction for Asia-Pacific at Goldman Sachs, are setting up an Asia-focused hedge fund in Hong Kong to be launched around April; and more than 10 “Korean-style” hedge funds were expected to make their historic debut on Dec. 23, according to the Financial Services Commission and the Korea Financial Investment Association. off with certain [running] costs of over 100%.”

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Robertson added he did not think the 2/20 fee structure hurts the performance of hedge funds enough to be brought down.

HFR: Hedge fund launches remain on pace for their highest year total since 2007
According to the Market Microstructure Industry Report released by HFR (Hedge Fund Research, Inc., a hedge fund data provider based in Chicago) in December also, new hedge fund launches declined to 265 funds in the third quarter of 2011 (3Q11), a decline of 15 over the prior quarter but representing a modest increase over 3Q10. Despite this quarterly decline, hedge fund launches remain on pace for their highest calendar year total since nearly 1,200 funds launched in 2007. Launches of new Macro funds have accelerated, representing nearly 35% of all single manager launches in both 2Q and 3Q, according to HFR. The number of Macro launches nearly equalled Equity hedge fund launches (39.6%) despite Macro funds representing only 21.6% of all hedge funds, while Equity hedge represents nearly half of all hedge funds. And despite what Julian Robertson said, hedge funds launched in the past 12 months (to December) have been offering investors lower management and incentive fees. Average management fees declined to 1.58%, a drop of 3 bps over the average management fee of funds launched in 2010, said HFR. Similarly, average incentive fees of hedge funds launched during the same 12-month period declined to 17.04%, more than 100 bps lower than the average of funds launched in 2010.

Robertson: the industry is tougher because there are more hedge funds being created
Julian Robertson, one of the few elders of the hedge fund industry, and the founder of the now defunct U.S. investment firm Tiger Management, told CNBC in December 2011 that the hedge fund business was getting tougher every day because there are more hedge funds being created. “And the reason for that is, it’s the best way to pay these very competent guys on Wall Street,” he explained. “So they matriculate into hedge funds. I think hedge funds would prefer to compete against the banks or mutual funds or individual brokers than they would against other hedge funds.” He believes it’s a tough business now and it’s going to get tougher, but: “The industry has a lot of legs because it is the best way to run money. But I think the easy times are over.” That’s because running a hedge fund has become so expensive: “When we started our business, we got a rebate at the end of the month on our free credit balances,” he said. “So to borrow stocks, we started off with probably a 3% cushion of profit. Now we start
ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

The Analytical View
Of those research reports and surveys that came out in late 2011, those that retained our attention revealed that young funds had outperformed older funds in 2010; that only 10% of the US foundations which invest in hedge funds will consider investing in new managers; and that 48% of investors, overall, would invest or consider investing in emerging managers (Asian investors being the most willing). Also, a 3-year track record and $100-499m in AuM are the most popular criteria for investors. But, to end on a positive note, new managers themselves expect to achieve returns of 10% or more, and raise around $50m in 2012 each.

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Only 10% of US foundations would invest in new managers, 4% would seed new fund
The 396 US-based foundations that are actively investing in hedge funds currently allocate around 16% of their total AuM to investments in hedge funds and many have plans to invest further, both over the next year and in the longer term, said Preqin in October. Preqin is a global provider of intelligence on the alternative assets industry. Foundations are typically long-term investors; as a result they are willing to accept longer lock-up periods and tend to favour more experienced managers. But New Managers, beware: only 10% of US foundations would consider investing in emerging managers and less than 4% would seed a new fund.

Young funds outperform older ones, with less risk
Small hedge funds outperform mid-size and large funds, and young funds outperform older ones, declared PerTrac, a large provider of hedge fund analytics, in September 2011. Its report, “Impact of Fund Size and Age on Hedge Fund Performance,” found that young funds (less than two years old) gained 13.25% in 2010, compared with gains of 12.65% for mid-age funds (two to four years old) and 11.77% for tenured funds (more than four years old). Moreover, young hedge funds appear to have achieved these returns with less risk than their competitors. PerTrac suggested several possible reasons why young funds excel, including that they were able to conduct portfolio changes more quickly and “under the radar,” that their less mature administrative and operational needs result in lower fixed costs, and that new technologies allow them to perform their activities more efficiently in more scalable environments. Monte Carlo simulations indicate this trend could continue in the near and intermediate future, according to PerTrac.

48% of investors overall would invest in emerging managers (58% of Asian investors)
Asian investors are apparently not as shy as their Western counterparts when it comes to investing in new hedge fund managers, said Preqin in December. Indeed, 58% of investors in the region are prepared to invest in such funds, compared to 39% of European investors and 48% of those in North America. Asian investors were generally less affected by the downturn than those based elsewhere, which could explain their continued, and indeed increased, confidence in such funds. Overall, 48% of investors would invest or consider investing in emerging managers, even in an increasingly difficult fundraising environment.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

The Analytical View
The willingness to invest in emerging manager funds varies with institution type; this is shown in the graph below:

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3-year track record and $100-499m in AuM most popular criteria, even if more talent on hand
28% of institutional investors interviewed by Preqin this year said that they were more open to marketing from emerging managers today than they were a year ago. One prominent fund of hedge funds told Preqin analysts that “although we have always invested in emerging managers we have definitely noticed that there is much more talent in the arena at the moment. A lot of talented men and women are starting hedge funds, so many that we wished we had more capital to invest in them!” In the mean time, most investors still prefer funds with a minimum of 3-year track record and more than $100m in AuM, according to these charts:

Source: Preqin
“In 2012, emerging manager vehicles are likely to appeal to investors disappointed by the returns from their existing hedge fund portfolios,” said Amy Bensted, manager of hedge fund data at Preqin. “Similarly, with fees also a key issue for institutional investors at present, emerging managers willing to negotiate fund terms with potential investors could also be successful in attracting capital.”

Minimum Track Record Requirement of Institutions Searching for New Funds

Source: Preqin
ISSUE 01 • January 2012 New Managers | Opalesque’s Emerging Manager Monitor

The Analytical View
Minimum AUM Requirement of Institutions Searching for New Funds

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new capital in 2012. The task of raising those assets will apparently fall heavily on marketers outsourced by the managers. When asked which activities they were looking for external partners or vendors, 41% listed marketing, followed by prime brokerage (37%) and compliance (30%). “The survey tells us that emerging managers are almost by definition brimming with self-confidence” said Amanda RodriguesCheung, GAIM USA’s Event Director. “Obviously, they have to think that they can outperform the markets, or they would not launch their funds.” That’s a given.

Source: Preqin

Let’s be optimistic here
According to a GAIM USA Survey of 90 emerging hedge fund managers (defined as having $250m or less in AuM) in December, 61% of the managers expect their portfolios to earn more than 10%, net of fees, while 31% of them expect to earn 15% or more in 2012. The survey also found that while emerging managers overwhelmingly (81%) cited “raising assets” as their biggest challenge, 40% of said that they expect to raise more than $50m in

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Profiles
Opalesque spoke to four of the emerging managers whose fund feature in the Emanagers database, Opalesque’s Solutions’ database of funds launched in the last four years. Two CTAs, one global macro fund and one equity long/short fund, all profited from the volatile market of late 2011. In December, global equity markets posted gains as both volatility levels and volumes fell, global government bonds rallied, commodities sold off (with gold losing 10%), credit markets rallied too, and investors continued to clamour for safe haven currencies, said a report from FRM, an independent hedge fund investment specialist, in early January. The report notes that there was a reduction in equity beta across the hedge fund industry. Fundamental strategies produced the largest losses as “the pronounced daily volatility since the summer has made conditions particularly difficult for deep value managers.” The best performers were found in systematic trading. The Dow Jones Credit Suisse Core Hedge Fund Index lost 0.41% in December (-7.40% for 2011); the Managed Futures strategy part of the index fared better with +1.82% (-2.95% for 2011); and so did Global Macro, with +0.38% (although not YTD as it is down 10%): and Long/ Short Equity did worse this month with -2.11% (-7.27% for 2011). A Connecticut-based CTA called Global Sigma Group LLC did well in the volatile markets this year. “The options market fully priced in the volatile market condition in September,” Hanming Rao, CIO, told Opalesque. “It was actually a very favorable environment for our short term trading model.” The $15m fund, Global Sigma Plus Program, launched in November 2009, gained 1.28% in December, and 20.09% in 2011. The volatile market environment also provided strong returns for all four programs run by 3D Capital Management LLC, a Princeton, New Jerseybased CTA. The firm’s systematic global macro programs are called “3D Blend” (up 42.91% YTD to end-October), “3D Intraday” (up 14.62% to end-November), “3D Bear” (up 22.53% YTD to end-November), and “3D Bull” (18.64% YTD to end-October).

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Greg Gravalis, manager at 3D Capital Management LLC, told Opalesque in November, “Our programs do well with volatility so the unease in Europe as well as the release of economic data and earnings here in the US has made for volatile and profitable markets.” But, he noted, the firm understands that in order to continue to be successful, it must stay disciplined and diversified and continue to put effort into research and development.

3D Capital Intraday Program
We also talked to a global macro fund which did very well too. Garen Ovsepyan, manager at the Beverly Hills, California-based discretionary money management firm Vanguard Axis LLC, told Opalesque: “The US debt ceiling issue too and the Eurozone problems again have also been profitable due to our close monitoring of our risk. Factors affecting our performance can always be blamed on volatility in markets, but volatility could also mean profits, so it works two ways. Overall, the fact that all our positions are un-leveraged and our risk/reward ratio is kept to around 1:3 helps us with the decision making process of the positions we take.”

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Profiles
The Vanguard Axis Managed Series fund, a global macro fund with $78m in AuM launched in June 2010, lost 0.5% in December but was up 33.38% in 2011.

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The Marlon Fund 1, which was launched in August 2010 and invests in US Mid Cap Equities with a Macro overlay, is down 2.88% YTD (to endDecember 2011).

Marlon Fund Vanguard Axis Managed Series
And finally, London-based boutique hedge fund LD Capital management’s team effectively tailored the firm’s exposures with the market swings. CEO Luc Sitbon told Opalesque that his directional equity long/short fund, Marlon Fund 1, was fairing well even during the current volatile environment because of their flexible strategy that allows them to make the necessary adjustments in case of large market swings in the market. Sitbon added, “At the end of July and the beginning of August in particular, Fixed Income markets were very stressed and Equity markets reacted with a lag. This situation enabled us to have an adequately hedged equity portfolio.” The Opalesque Solutions Emerging Managers Database is an extremely niche and specialised database of Emerging Hedge Fund Managers, and access is available for eligible investors such as Funds of Funds, Family Offices, Pension Funds and HNWIs globally as well as academia and research analysts.

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Profiles
New Funds in the Emanager database (December 2011) Fund name
Goshawk Global Fund LP Goshawk Value Fund LP Farema Capial European Equity L/S Fund

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Strategy
CTA - Equity index Directional - Equity long/short Directional - Equity long/short

Location
United States United States Luxembourg

AuM
$8.30m $15m -

Launch date
Jan-09 Jan-10 March-10

ISSUE 01 • January 2012

New Managers | Opalesque’s Emerging Manager Monitor

Perspectives
In the last quarter (Q4-2011), Opalesque recorded a lot of commentaries coming from the hedge fund industry on what new hedge fund managers should and should not do, the problems they are encountering, the opportunities that are awaiting, and generally what’s in store for them. Here are a few snippets of the “global conversation” about our hopeful start-ups.

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current volatility and is aware of investors’ restraints when it comes to investing in emerging managers, then he should get through the door – with both feet. The first thing that Bryan Borgia, co-founder of Topwater Investment Management, does with new managers, he revealed at the recent Opalesque Connecticut Roundtable, is have a 15-30 minute phone conversation to discuss their firm and strategy. “One common theme I see is that many managers still struggle with the proverbial elevator pitch,” he observed. What they should do is break down into one paragraph what exactly sets them apart from their peers, and clearly define their potential edge. But for example long/short managers who believe their edge is being plus or minus 20 net should not define this as an edge but as a portfolio construction, he noted. Here is more advice for the hopeful: the fund managers sitting around the recent Opalesque Roundtable in Pfaeffikon, Switzerland, agreed on how tough the environment is – and will be – for hedge fund start-ups. They said that (1) focusing on performance in the initial period, (2) being transparent, (3) demonstrating a high level infrastructure and employing top service providers, (4) and avoiding wasting time on appearances (with flashy offices and costly marketing) will increase their chances of success in a marketplace where investors are – rightly so – thinking twice about whereto place their money.

Trends in LatAm, in boutiques

While some of our communicators see a trend in funds being launched in LatAm, others see a return to investing in boutiques. Most new managers global law firm Walkers has seen come from established hedge funds, others from banks. Setting up with $10m or $20m is no longer popular, as more capital is needed to survive. Thankfully, many managers are getting significant amounts of seed capital now. Walkers also sees a trend in the growth of funds launched by managers in South America, particularly Brazil and Chile. The law firm, which has a group there now, expects more activity there from now on. A trend that Alexandre Col noted is the renewed interest in boutiques. He is the head of investment funds at Geneva-based Banque Privée Edmond de Rothschild. As a fund of hedge funds manager (FoHFs), he used to be in favour of investing in large hedge funds because they attracted talents, he said. Even more so after ’08. However, today, he is looking at new managers, at diversifying his portfolio and building a niche strategy. Now is the right time for that, he thinks.

Here is some advice for you

Allocation trends: away from the big guys

At a conference, several investors and FoHFs managers discussed what a new fund needs to do to entice investors. They said that if a fund manager can attract trust, be proactively open about his operations, be able to explain its strategy to pension boards, if he has a history and modus operandi relevant to his strategy, is able to protect his fund against downsides, takes advantage of the
ISSUE 01 • January 2012

Many are also expecting more start-ups going forward, which may create an even more competitive environment. But there is still hope for emerging managers, as some investors, tired of bloated underperforming funds, might start moving money to newer and smaller managers, a trend that was confirmed by a recent study by Barclays Capital.

New Managers | Opalesque’s Emerging Manager Monitor

Perspectives
The pendulum of fund allocations is swinging back to small and emerging managers. Although the large majority of assets flowing into hedge funds are still allocated to the very large funds, things are looking up for emerging managers, said participants at the latest Opalesque New York Roundtable. “I believe it will rotate, said Joe Taussig, founder of financial consultancy Taussig Capital. He added, “The emerging managers historically have always outperformed the big guys.” This was echoed by Todd Groome, Chairman of the Alternatives Investment Management Association (AIMA), who believes that in 2012 allocations to the industry will continue to rise across the board, to big firms and to start-ups and emerging managers. He told Opalesque in an interview: “I believe the industry will continue to grow. Certain funds may see redemptions, but my perception is that if they take funds from manager x they will reallocate it to managers b and c.”

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More seeding

Emerging managers face headwind in the current climate and also have to meet new regulatory demands. To survive, they need to raise enough assets to support the necessary infrastructure. Fortunately for them, this coincides with a current growth in the fund seeding business, said the participants of the Opalesque Connecticut Roundtable. Indeed, some large institutions, such as Goldman Sachs, Hermes BPK, CalPERS and Blackstone are now starting to seed new funds. Even hedge funds, such as Maverick Capital, AQR are doing it. And new seeding platforms are emerging too. Jeroen Tielman, founder and CEO of such a platform, IMQ Investment Management, said at the Opalesque Amsterdam Roundtable that the new managers that IMQ seeds get very special treatment: “Emerging managers have increased operational risks in the first year of operation and we are reducing this risk by having them locate in the same office as where we are located in order to do a better guiding and monitoring. Liquidity needs to be synchronized so that the liquidity promised by the fund matches the underlying liquidity of the investments. As a seeder, we want to see full transparency and clear communication about that by the investment manager.”

Challenges

Scott Price, VP of Custom House Global Fund Services, said at the Opalesque New York Roundtable that emerging managers just keep on coming. In fact, they have in their pipeline many hedge funds that are scheduled for launching within the next six and 10 months. To run a successful asset management under the current conditions, managers are faced with many demands and challengers, a lot of which are “outside the scope of a successful trader.” Price explained that a new manager has to do with many things that three years ago would be non existent. Today’s investors are more scrutinizing and demanding and will require managers to present them with a clear marketing pitch, a very detailed business plans, compliance functions, as well as due diligence and transparency. He clarified that although many of the new launches were headed by people coming from banks, the majority of them have come from large hedge funds, who have decided to go on their own and not be a part of the larger fund any more.
ISSUE 01 • January 2012

Opportunities

Claude Porret, the founder and CEO of Swiss-based 47 Degrees North Capital Management, an asset management firm specializing in emerging managers and innovative strategies, said on Opalesque TV that she built the firm around the idea that the hedge fund industry was going more and more towards new, specialized products. This understanding of the industry also led her to find that early-stage fund managers may actually be better in terms of limiting downside risk than established fund managers or fund ‘legends.’ This view of the industry differentiates Porret from many others that consider emerging managers to be inherently risky.
New Managers | Opalesque’s Emerging Manager Monitor

Document Disclosure
This newsletter is designed to include a wide variety of industry voices and information. To participate, send your news, events and viewpoints to gravrand@opalesque.com. To be considered for inclusion information must be factual, not promotional in nature and ideally address deep industry issues and reveal insight into how strategies operate, all delivered from a balanced perspective that addresses risk frank terms.

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